Market computer breakdowns manageable by industry, traders say

Eliminating all trading errors is impossible and the way to address malfunctions that have plagued equity markets this year is to improve testing and oversight, industry executives said at a meeting in Washington.

Principles such as independent design, redundant risk measures and a preference for frequent, incremental changes to software will limit the inevitable mistakes by humans and computers, Getco LLC said in written testimony. Assertions that trading was more orderly in the past are baseless and too much regulation will penalize investors, according to Citadel LLC.

Spurred into action after Knight Capital Group Inc. bombarded exchanges with errant orders on Aug. 1, the Securities and Exchange Commission called today’s meeting to explore ways of limiting the effect of technology malfunctions. Technology executives of firms that specialize in automated trading said regulators have a role in improving controls, while cautioning against rules that might make the situation worse.

“We believe that a firm’s systems, protocols and procedures should be designed with the knowledge that there will be human mistakes and technology breakdowns that lead to trading errors and system failures,” Chicago-based Getco wrote.

Today’s roundtable was scheduled after SEC Chairman Mary Schapiro, whose agency is the securities market overseer in Washington, described the Knight event as “unacceptable” and promised to issue regulations to help prevent similar mishaps.

Technology ‘Pitfalls’

Knight, one of the biggest market makers in U.S. stocks, lost $440 million and avoided bankruptcy only after a cash infusion from investors following its software breakdown. The error followed mishandled initial public offerings by Facebook Inc. and exchange-operator Bats Global Markets Inc.

“Technology has pitfalls,” Schapiro said today in prepared remarks. “And when it doesn’t work quite right, the consequences can be severe. Trading can be disrupted, investors can suffer financial loss, firms can be imperiled and confidence in our markets broadly can erode.”

She compared the potential consequences of trading errors to traffic lights that flash the wrong color or railroad track switches that send a train to the right instead of left.

Getco, which makes markets on the floor of the New York Stock Exchange and on other venues across asset classes, outlined a set of programming values it said would minimize trading disruptions. It said systems should be independent of each other to keep errors from cascading, firms should prefer smaller, incremental changes over larger ones so that when errors occur they can be easily fixed, and risk controls should be layered and redundant, according to its written testimony.

‘Testing Protocols’

“Good testing protocols increase the likelihood that errors are identified and corrected,” the firm wrote. “There is not a specific testing discipline that is appropriate for all firms. Instead, the specific procedures will vary depending on the size, scope, trading strategies and business lines of that firm.”

The SEC fueled the march to electronic trading when it passed rules starting in the 1990s designed to drive down costs for investors. In 2005 it approved rules to increase competition with the then-dominant New York Stock Exchange. Now more than 50 venues get trades that are mostly handled by computers.

Critics say the policy may have worked too well, fostering so much fragmentation that the SEC and other regulators can’t get a handle on what is happening in far-flung trading venues until it’s too late. Knight’s loss is a “wake-up call” to the industry that highlights the interconnectedness among markets, Schapiro said.

“Our multi-venue, interlinked market structure also means that an infrastructure failure by one party or at one venue may cascade into other venues and affect many other participants,” Schapiro said. “And of course the inherent speed of trading, which itself is partly a result of the competitive nature of our markets, means that even small, short-lived infrastructure issues can cause drastic harm.”